Jim MacCrate, MAI, CRE, ASA has his own firm, MacCrate Associates, but has worn many hats as a Director at PricewaterhouseCoopers in New York City and Chief Appraiser at European American Bank. He is a prolific writer on valuation issues and teaches a number of the real estate appraisal classes through the Appraisal Institute and New York University. I have had the pleasure of taking a number of courses taught by Jim. His wife Judy is an SRA and is an accomplished appraiser in her own right, having managed an appraisal panel for a large lending institution throughout its various mergers for a number of years. I can only imagine the riveting conversations at dinnertime.

UPDATE: Mark your calendar, Jim has been invited by the Wisconsin Chapter of the Appraisal Institute to address distressed commercial real estate properties for professionals including real estate brokers, owners, and appraisers. The Appraisal Institute is inviting the FDIC to attend this critical and timely seminar on August 27th, 2008 in Milwaukee, Wisconsin.

Here’s how to sign up for the seminar.

…Jonathan Miller

Real estate appraisers have to be wondering what property values are doing in Manhattan and elsewhere. Clearly, the real estate market is being hit by numerous factors that are affecting property values. The following chart indicates how Manhattan apartment values have changed in comparison to changes in the nationwide apartment value index, CPI index and applying capitalization rates to the projected changes in income to develop indexes based on the average and median long term (20 plus years) capitalization rates. From 1998 through 2003, apartment value trends followed the CPI very closely.

The nationwide apartment value index followed a similar pattern to New York’s until 2003. If the long term average or median capitalization rate is applied to the projected net operating income, apartment values in Manhattan would not have kept pace with inflation in New York.

Impact of Financing

Other factors drove the increase in apartment values. The following chart indicates the path the apartment capitalization rates took for the last eight years or so. Optimism, lower interest rates, huge capital inflows (beginning in the latter part of 2003) and tax free exchanges drove apartment prices into a bubble that is waiting to collapse.

If it is true that over the long term real estate values keep pace with inflation and returns regress toward the mean, Manhattan apartment values are in for a rough ride. If rates of return do regress toward the mean as interest rates increase, a large drop in value is indicated or values will remain stable waiting for the CPI to catch up. During the 1970’s and early 1990’s, apartment values declined and, then, stabilized for several years.

But Wait.

Not only are interest rates and debt coverage ratios increasing, all operating costs are increasing quite rapidly in the New York area. The NYC RGB forecasted the following expected increases in operating expenses from April 2007 through April 2008 for all apartment projects as follows:

During the first six months of 2008, fuel costs have already reportedly increased 20% annually. Real estate taxes will have to be increased more than expected to cover the shortfall in city revenues from other sources. All other costs will probably follow the inflationary spiral that has begun. Increases in rental income generally lag expense increases.

What will hurt apartment values will be increasing capitalization rates, operating costs and switching from interest only loans to amortizing loans. It would not be surprising to see an increase in delinquencies within the next six months or so. Lenders will be forced to modify loans or foreclose.

In addition, the New York City Comptroller’s Office issued a report stating “the real estate sector accounted for nearly $200 billion of the New York metropolitan area’s gross product in 2005, showing a location quotient of 1.3, or 30 percent higher than the national average.” That sector is contracting along with the financial services sector which accounts for 13.6 percent of the regional economy. Job growth is slowing and unemployment is rising.

So, The Question Is Not If But When?

The following chart provides a summary of the estimated apartment capitalization rates over time.

With capitalization rates falling below 6.00% during the mid-2000, it is only a matter of time for the rates to regress back to the mean and let the air out of the balloon. The events unfolding were predictable and the general historical patterns are similar. Financial regulation and sound underwriting policies disappeared during this time period of “irrational exuberance.”